IRS examination program undergoes re-engineering

The Internal Revenue Service Examination Re-engineering Project — the organization’s first comprehensive revamp of its audit process in 50 years — has resulted in new procedures for determining the scope of the examination, practitioner involvement in setting the schedule, and an increased role for IRS managers to play in the entire process.

The planning changes involve clear, direct communications between all parties, starting at the first interview. IRS examiners will work with practitioners and their clients to focus on the specific issues in question, set an agenda, and agree on a “mutual commitment date” — a flexible target date for the examination to come to a close.

The point of the process is to produce more efficient and better quality examinations, according to William Conlon, director of reporting compliance in the Small Business/Self-Employed Division.

The restructured audit project began roughly one year ago.

“There are really three main components of exam re-engineering that we’ve taken a look at and made some improvements to, and that’s the planning of the examination, the managerial involvement in those examinations, and the risk analysis to assist in determining whether we should expand or contract the scope of those audits,” he said.

Of the IRS-wide tax gap, 74 percent is attributable to SB/SE taxpayers, Conlon noted. For 2005, he said, the IRS will focus on the areas that it believes are the most noncompliant.

“In order of priority, tax avoidance transactions will continue to be the No. 1 item for us,” he said. “We’ll have high-income/high-risk taxpayers, high-income non-filers, unreported income cases and, for the first time in a number of years, we’re going to get back to what I call the criminalexamination workload, which will include corporations, S corporations and partnership returns.”

At the same time, he noted, the operating divisions of the IRS are committed to doing a better job of working with the Office of Professional Responsibility to deal with practitioners who try to defeat the system through delay.

William Marshall, project director for the re-engineering program, said that both taxpayers’ and practitioners’ biggest complaints are the length of the audit. “If we can better plan the audit, better communicate, use risk analysis and have managerial involvement, that will greatly improve the number of first appointment closures,” he said.

Tax avoidance transactions, the No. 1 priority, will be attacked from a number of directions, according to Marshall. “One is the promoter, their activity, their own return. The other aspect of it is the client returns that they have affected.”

“If it’s a promoter who has a few clients,” he continued, “the revenue agent may go ahead and pick those up. If we have hundreds, or even thousands, which we’ve run into in some situations, we’ll use office audit, or even campus resources to bring those returns into compliance if need be.”

The second priority, the high-income/high-risk taxpayer, is not an effort to single out the wealthy. “We’re not just picking people for audits who have alot of money,” said Marshall. “We’re trying to identify those people who have not only been successful, but also extremely aggressive in the tax treatments that they have used. And we’ve got filters, I think, to get us to the right population.”

The high-income non-filer is a third category that will receive increased focus. “We’re going to continue to deal with high-income non-filers,” according to Marshall. “For the field, certainly, those non-filers that have businesses, we’re going to send a revenue agent out there to make sure that we get the appropriate amount of income reported. It would be nice if they would put it on the return for us, but if not we can provide that service.”

A finer filterTo aid the IRS in its selection of returns, the Unreported Income Discriminant Function System, or UIDIF, was developed.

The Discriminant Function System, or DIF, is the computer program used by the IRS to select most returns for audit.

“For those familiar with the old DIF filter, we’re still using that, but that’s an expense-based scoring model,” said Marshall. “It was never designed to pick up an item that was not reported on a tax return. So we developed the UIDIF filter, and deployed it about 18 months ago for the first time across a broad range of taxpayers.”

“What we found for that is that it’s not effective at lower income levels, and wage-earner levels,” he continued. “It does seem to be effective on the business side, and the higher income levels, and certainly a number of the fraud referrals that we’ve had over the past year have been a direct result of using those UIDIF filters and the returns that were examined through that.”

The revelations were made at a discussion hosted by Tax Talk Today, a forum co-sponsored by the IRS, designed to provide education and information for the tax practitioner.

The benefits of re-engineering particularly resonated with the tax practitioners on hand.

“Anything that helps get an audit done faster and more effectively is good,” said Mary Lou Gervie, a CPA and senior tax manager at Washington-based Watkins, Meegan, Drury and Co. LLC. “We love it when a revenue agent tells us what issues they want to look at. For an accountant, it helps to dialogue before the IRS starts the audit. In the past, they had blanket document requests, even though they might just need to focus on a few issues.”

The changes in the program are expected to become effective as soon as all examination professionals are fully trained. Although three-quarters of field examiners and one-half of office examiners are now trained, Gervie said that most revenue agents have been trying to work under these guidelines for the last year. “They are being much clearer up front as to which issues they want to audit,” she said.

Audits of corporations, S corporations and partnerships will soon be at higher level, according to Conlon.

“Over the last couple of years we had to give up some work in order to focus on the priorities we had,” he said. “Now that the 1040 phase of the [National Research Project] is complete, we’re taking some of the capacity that generated for us and going back to corporate audits and audits of flow-throughs.”

“Consistent with other things we’re doing, I believe these are going to continue to be issue-driven, focused examinations,” he continued. “They’re not fishing expeditions that we’re going to be taking out there.”

He added, “The whole examination environment is changing into focused examinations, issue-specific. The point is to put our cards out on the table at the very beginning and get things resolved as soon as we can.”